Bill Smead, founder of Smead Capital Management, thinks that a generational change will give the US economy an unexpected boost. The renowned value investor spots opportunities in homebuilder stocks and blue chips like American Express, Disney and Home Depot.
Millennials are perceived as the «lost generation». Born in 1981 to 1996, they have been rattled by the financial crisis and are drowning in debt, or so goes the common narrative. What's more, their unconventional spending patterns are held responsible for the anemic growth perspectives of the US economy.
Bill Smead thinks that’s utter nonsense. The highly regarded founder of the Seattle based investment firm Smead Capital Management is convinced that millennials won’t do things differently than their parents and grandparents. In his view, the only real difference to previous generations is that today, more people graduate from college and therefore wait longer to start a family.
According to the experienced value investor this means that in the coming years the focus of investors «will turn from technology-oriented companies which can do exciting things in an anemic environment to main street, on the ground, real life economic activity which is driven by household formation.»
Against this backdrop, he bets on homebuilder stocks like NVR and Lennar as well as on blue chip names like Home Depot, Disney and American Express. In this extended interview with the Market, he also explains why he has trimmed down his stake in Berkshire Hathaway.
Mr. Smead, after last week’s turmoil stocks are on the rise again. What’s your take on the financial markets?
We’re in the crazy stage and if you are flirting with things which are benefiting from the crazy stage you are playing with fire. Maybe valuations are not quite as completely stupid as they were in early 2000. But that’s like saying “Bill Smead is handsome” because I’m comparing him to an Ogre. I’m not handsome, but compared to an Ogre I am.
What does this mean for the outlook at the stock market?
You have to understand that value is record cheap versus the market. I started in the investment business in 1980 and today, value is the cheapest to the S&P 500 in my entire forty years in the business; even cheaper than 1999/2000. There is complacency everywhere but value. That’s because cheap stocks have become volatile and no one wants to own volatile. No one wants to own cheap. That’s also why there is a huge premium on defensive stocks versus cyclicals.
How does an experienced value investor like you navigate this kind of environment?
Like any good business person, you need to have a vision of what you think the next five to ten years are going to look like. That’s because that vision is an important factor in your ability to produce returns above and beyond what the index is going to provide. The first way to understand what’s going to happen in the next five to ten years is to understand what is extremely popular now and why it’s extremely popular
So what is your conclusion?
What has been extremely popular in the United States is enjoying our economy relative to other economies in the world, even though the US economy was underperforming relative to the growth in past areas. In other words: accepting this more muted, less dynamic economic growth pattern and then investing accordingly. This meant looking for businesses which can do extremely well despite the anemic growth pattern. This mindset has dictated what the stock market has done pretty much for the last ten years: The price being paid for growth has risen and risen, and simultaneously interest rates have moved lower and lower justifying these high prices.
And what’s going to happen next?
Technology stocks did well in an environment dominated by 80+ millennials who were single and whose spending was dictated by choice rather than necessity. But the group of people who are currently 21 to 38 years old is 40% larger than the generation they are replacing in that age cohort. So when 40% more people get crammed into the 30 to 45 age group, a lot of economic activity on the main street level happens which wasn't happening in the prior decade. This means that the focus of investment success could turn from technology-oriented companies which can do exciting things in an anemic environment to main street, on the ground, real life economic activity which is driven by household formation and soccer moms.
Why do you think soccer moms will have such an important role in the US economy?
The soccer moms of the baby boomer generation re-elected President Bill Clinton in 1996. 23 years later, it’s the children of these soccer moms who will drive the US economy. This new millennial generation of soccer moms will be driving multi passenger vehicles that handle car seats and a lot of junk. They will want to buy a house and get out of their apartment crammed in next to everybody else in the inner city. This means we have a lot of homes to build in the US, we will have a lot of kids apparel and shoes to buy and we have a lot of expenses based on necessity rather than on choice. That’s the vision that goes across the top of our portfolio.
Then again, in the US and around the world, the economy is weakening and may even go into recession.
Whatever economic slowdown we have in the United States is likely to be mild in nature because the force of the millennials is already hitting. For example, there is a noticeable and meaningful pick-up in home building in what we call the exurbs: the highly populated coastal areas an hour and a half away from the cities. What’s more, the cities that are not on the coasts which have affordable housing like Kansas City, Des Moines, Iowa, St. Louis or Albuquerque are all seeing a very high activity in home buying and building. Never forget: money always goes where it gets treated the best.
Is this the reason why the homebuilding company NVR is the largest position in your portfolio?
NVR caters to first- and second-time home buyers on the eastern seaboard. Our investment discipline is always governed by our eight criteria and NVR is a superior company in just about every way of measuring: solid balance sheet, high profit margins, high return on equity, shareholder friendliness and heavy insider ownership: The people who run the company own 9 or 10% of the business.
Where else do you spot investment opportunities against this background?
As the millennials age, certain spending patterns are going to develop. It’s going to be pretty obvious to everybody and then investors will start chasing these spending patterns: As you go down this list of patterns, it’s just a whole bunch of things that people who are 35 to 40 with two kids spend all their money on: Mortgage interest and charges is number one, followed by kids apparel, other apparel and services, shoes as well as vehicle finance charges. That’s the sweet spot in the United States for the next ten years and the stock market is completely unprepared for that.
How do you take advantage of this sweet spot?
For instance, American Express might be a better credit card company to own than Visa or Mastercard. That’s because American Express is a bank and can lend the money to their customers. Visa and Mastercard do not lend the money, they only process the transactions. This will be a huge advantage for American Express because they recur 9% interest on the spread if people choose to leave a loan balance outstanding. So the lending part of the business will become the most profitable part. In the past, the transaction part was the most favorable part since no one was borrowing the money. It was easy and there was no credit risk. But when 80+ million people come to borrow money and most of them are going to be creditworthy, you want to take that risk. That’s why we’re also overweight the big banks which issue credit cards: JPMorgan, Bank of America and Wells Fargo.
But aren’t many millennials already carrying a lot of debt?
The media hyped narrative that millennials are deeply in debt is an urban myth. True, they have more student debt than any generation before them and it’s not optimal that people graduate from college with a lot of student debt. But that’s because 65% of high school graduates in the United States go to college today. When I graduated from high school it was 25%. So keep in mind: the average college graduate in the US makes about $30’000 a year more than someone who doesn’t graduate from college. So to take out a student loan should turn out to be one heck of a great investment. Also, there is no evidence whatsoever that people who take out a college loan and get their degree buy houses and form households at any lower rate than previous generations. In fact, in some ways it teaches them that borrowing money for the right reasons is worthwhile.
On the other hand, most studies show that millennials have been hit hard by the financial crisis, are living longer with their parents and are slower when it comes to start a family.
Everyone thinks that millennials are not going to be as domestic, are not going to get married and don’t have kids. They’re not going to buy houses and they’re not going to do all the same things that other generations did because people think that technology has caused their attention spans to be too short to make babies. All that is total hogwash. Millennials are going to do the same things like other generations. They are just going to do it later in life because 60% of college graduates are women. They graduate from college and get a career established before they get married and have kids. So they are slower getting off to a start. But that’s ok, because they all are going to turn 35 to 45 and they are going to get the ball rolling down the hill.
Other large stakes in the Smead Value Fund are healthcare stocks like Amgen, Merck and Pfizer. What’s the bull case there?
Medicines have a very bright future. In the US, there are more than 70 million baby boomers who have just entered the key years when they massively scarf down enormous amounts of medicine on chronic illnesses to avoid the most expensive part of the US healthcare system: doctor visits, hospitals and ER visits. So we are enthusiastic about Merck and Pfizer and we are very positive about Amgen. Amgen sells a medicine that lowers your bad cholesterol and cuts the risk of heart attacks and strokes by 20 to 25%. That’s going to be a mega hot seller. I might have my doctor prescribe it to me even though I don’t have high bad cholesterol just so I can have the blood of a marathon runner.
You’re also invested in Home Depot and Disney. Where do you see value in these stocks, since they don’t look really cheap?
Disney and Home Depot are trading at 20 times earnings. In contrast, everybody in the growth category who can walk and talk and chew gum at the same time trades at 30 to 40 times earnings. That would be stocks like Nike, Visa, Mastercard, Costco and Starbucks. I can give you a long list of glam, mature growth stocks that trade at 30+ times earnings. So what is the difference between Home Depot, Disney and theses stocks? The answer is: It’s just psychology. There is no evidence whatsoever that these companies will perform better than Home Depot and Disney with the demographics we have the next 15 years.
Still, the share price of Disney just recently reached an all-time high. The same is true for Home Depot.
Let me tell you something: Warren Buffett says that he made the biggest mistake in his entire career with Disney. In 1965, Buffett bought 5% of the entire Disney corporation for $4 million. At that time, Disney was about a thirty-year-old company and a year later Buffett sold his stake at a 50% gain. Today, Disney has a $250 billion market cap. So 5% would be $12.5 billion - and I’m not even counting dividends. I bring this up because most people think that active managers would do better if they were smart about selling stuff after it runs up. I argue that the academic evidence for long stretches of time says just the opposite: The biggest mistake we all make is not holding our winners to a fault. In the bible love covers a multitude of sins. In the world of portfolio managers, ten baggers cover a multitude of 20 to 40% losers.
A year ago, Berkshire Hathaway was one of your largest positions. Today, the stock is not in the top ten holdings anymore. What happened?
We still own Berkshire Hathaway but we de-emphasized it quite a bit. That’s because Warren Buffett and Charlie Munger are getting way up there in years and I think that’s why they’re holding this massive stash of cash: If it was announced that Buffett or Munger went to the hospital there would be a drop in the stock price of Berkshire Hathaway immediately. So they have that heavy artillery there to be prepared and to do stock buybacks when it happens.
What’s more, Buffett has had some setbacks lately. For instance, Kraft Heinz, one of his largest investments, has lost around 70%. Has the “Sage of Omaha” lost his golden touch?
I don’t think so. But he has lost his willingness to offend people by saying what’s going on in the market. For example, he’s not going to say that AI and data analytics look like an overcooked goose because he’s buddies with Bezos and all the guys who are making the money from AI and the overcooked goose. He doesn’t want to die with enemies. He wants to die with everybody being his friend.
Is that the reason why Berkshire now owns a $1 billion position in Amazon and Apple has become Buffett's largest position in the stock market?
Buffett has a position in Amazon because one of his underlings that he hired to pick stocks bought Amazon. Buffett had nothing to do with that. In the case of Apple, Buffett got interested in the stock because one of his underlings owned it and he concluded that it is a consumer brand not a company that sells electronic hardware. It switched his brain in a completely different direction and Apple became a company like Coca-Cola to him.
What’s your general take on FAANG stocks like Amazon, Netflix or Facebook?
If you owned these three stocks over the last twelve months, you lost money while the market has been going up. This is the first time you can say that in this bull market. So the goose which laid the golden eggs is already dying. It’s likely that we have been in a topping process on technology that really started a year ago. Just look at a chart of Amazon: For the third time, the stock has now failed to break through $2000. Meanwhile, Wall Street is successfully fleecing people by issuing shares of a bunch of exciting, young unproven companies of which probably 90% will fail ultimately. Still, people are the most excited about the things they have been excited about the prior eight to ten years. That’s the way it always happens. We like to refer to it as the beyond meat market. That’s one of the craziest stocks of them all.
So where do you spot real value these days?
Today, the oil and energy sector has the smallest weight in the S&P 500 in my career since 1980. The weight of the energy sector has ranged from the current 4.6% to a high of 16% in 2008, when oil peaked above $140 a barrel. Gasoline, motor oil and all that kind of stuff may have dropped 5% in the last four decades. But the United States still runs on gasoline.
Is that the reason why you recently added Schlumberger and Occidental Petroleum to your portfolio?
When the China mania was going on back in 2011/12, we wouldn’t have touched an oil company with a ten-foot pole. Today, our attraction to oil is a psychological thing that says: wait a second, the importance of these products and producing them compared to the market capitalization is completely out of line. It’s like buying American Express after they divorced Costco or buying Target when Amazon announced they’re going into the grocery store business. It’s comparatively easy.